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Court Papers Undercut Ratings Agencies' Defense

Documents in a civil suit in federal court appear to threaten a legal defense that credit ratings agencies have long used to fend off liability for misjudging securities that later cost investors vast sums in losses.

For years, the ratings agencies have contended that the grades they assign debt securities are independent opinions and therefore entitled to First Amendment protections, like those afforded journalists. But newly released documents in a class-action case in Federal District Court in Manhattan cast doubt on the independence of the two largest agencies, Moody’s Investors Service and Standard & Poor’s, in their work with a Wall Street firm on a debt deal that went bad as the credit crisis began.

The case, filed in 2008 by a group of 15 institutional investors against Morgan Stanley and the two agencies, involves a British-based debt issuer called Cheyne Finance. Cheyne was a structured investment vehicle, created in 2005, that raised $3.4 billion in short-term debt from investors. The company was meant to profit by purchasing longer-term obligations that generated more in interest than the company paid to its lenders.

But Cheyne collapsed in August 2007 under a load of troubled mortgage securities. The institutions that bought almost $1 billion of its debt, including the Abu Dhabi Commercial Bank, the fund manager SEI Investments and the Public School Employees’ Retirement System of Pennsylvania, lost much or all of their money.

The investors have argued that their losses resulted from fraud and negligence by Morgan Stanley, which marketed the deal, and the ratings agencies that graded it highly. They contend that the agencies knew the data and assumptions used to assess Cheyne’s obligations did not support the ratings, which did not reflect the risks in the portfolio.

Lawyers for Morgan Stanley and the ratings agencies have countered that the losses were caused by a decline in market prices that was unrelated to credit performance. “We believe the allegations in this case are without merit,” a spokeswoman for Morgan Stanley, Mary Claire Delaney, said. “We have defended ourselves vigorously throughout this litigation and will continue to do so.”

Representatives from both Moody’s and S.& P. said that the case was without merit and that the documents were taken out of context. They also vowed to defend themselves vigorously in the matter.

A Moody’s spokesman added, “Our ratings are fully independent and based on robust and objective analytical criteria.”

The lawyers representing the plaintiffs declined to comment on the filing.

When Cheyne issued its various securities in 2005, Moody’s and S.& P. rated them all investment grade. Even though Cheyne’s portfolio was bulging with residential mortgage securities, some of its debt received the agencies’ highest ratings, a grade equal to that assigned to United States Treasury securities. About two years later, as mortgage losses began to balloon, both agencies downgraded Cheyne’s debt below investment grade, to what is known as junk.

After the institutions that bought Cheyne’s debt sued Morgan Stanley and the ratings agencies, Moody’s and S.& P. immediately mounted a First Amendment defense. But Shira A. Scheindlin, the federal judge overseeing the matter, ruled in September 2009 that it did not apply because the Cheyne deal was a private offering whose ratings were distributed to a small group of investors and not the public at large. Judge Scheindlin agreed with the plaintiffs, who argued that the ratings were not opinions but were misrepresentations that were possibly a result of fraud or negligence.

“The disclaimers in the Information Memoranda that ‘a credit rating represents a rating agency’s opinion regarding credit quality and is not a guarantee of performance or a recommendation to buy, sell or hold any securities,’ are unavailing and insufficient to protect the rating agencies from liability for promulgating misleading ratings,” Judge Scheindlin ruled.

The judge also ruled against the defendants’ motion that documents and depositions generated in the case should be sealed. As a result, e-mails and deposition transcripts were filed with the court on Monday, showing how closely agency officials rating the deal had collaborated with Morgan Stanley, the firm that hired them to rate Cheyne’s securities.

For example, when the primary analyst at S.& P. notified Morgan Stanley that some of the Cheyne securities would most likely receive a BBB rating, not the A grade that the firm had wanted, the agency received a blistering e-mail from a Morgan Stanley executive. S.& P. subsequently raised the grade to A.

And when a Morgan Stanley colleague asked for information about the Cheyne deal, Rany Moubarak, an analyst at Morgan Stanley on the deal, wrote in an e-mail: “I attach the Moody’s NIR (that we ended up writing)” referring to the new issue report published by Moody’s in August 2005.

The court filings also demonstrate a lack of methodology for analyzing the Cheyne debt. For example, in an e-mail before the deal was sold, S.& P.’s lead analyst wrote to a colleague: “I had difficulties explaining ‘HOW’ we got to those numbers since there is no science behind it. The documents show that the lead analyst at Moody’s noted there was “no actual data backing the current model assumptions” for segments of the Cheyne deal.

The ratings agencies were also reluctant to turn down business from issuers of complex securities like Cheyne, the documents show. Perry Inglis, a former managing director in S.& P.’s structured finance unit, wrote to colleagues in an e-mail in February 2005: “I don’t want to miss one deal because of our model assumptions either. Is there any possibility of ‘tweaking’ the default table to get all of this so that we don’t have to compromise?”

A version of this article appears in print on July 3, 2012, on page B1 of the New York edition with the headline: Court Papers Undercut Ratings Agency Defense. Order Reprints|Today's Paper|Subscribe